EU withdrawal scenarios and monetary and financial stability: A response to the House of Commons Treasury Committee (w PDF; 28/11/2018) | Bank of England
https://www.bankofengland.co.uk/report/2018/eu-withdrawal-scenarios-and-monetary-and-financial-stability
The below excerpt is on our own.
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Executive Summary
Analytical Foundations
… This analysis includes scenarios not forecasts. The scenarios illustrate what could happen, not necessarily what is most likely to happen under a range of key assumptions. …
… The Monetary Policy Committee (MPC) and Financial Policy Committee (FPC) have reviewed the relevant scenarios…
Key Economic Relationships
The impact of Brexit will depend on the direction, magnitude and speed of the effect of reduced openness on the UK economy.
Direction: The direction of the effects of a reduction in openness is clear: a weakening in both supply and demand, a lower exchange rate and higher inflation. …
Magnitude: The magnitude of the economic impact of the underlying assumptions is modelled using established empirical economic relationships. …
Speed of adjustment: Given the lack of precedents, there is uncertainty over the speed of adjustment to reduced openness. Empirical studies generally examine the effects of trade integration. …
- …it is likely that the corporate sector is generally not yet well equipped to cope were the UK to leave the EU without a transition period.
- The experience of New Zealand as it de-integrated from the UK following the loss of Commonwealth preferences in 1973.
Scenarios
… i) as the path the economy is currently on, represented by the MPC’s most recent, November 2018, forecast; or ii) as the path the economy was on prior to the EU referendum, represented by the MPC’s May 2016 forecast.
Economic Partnership under the Withdrawal Agreement and Political Declaration
No Deal No Transition Scenarios
… To assess the ability of the banking system to continue lending to households and businesses in the most adverse outcomes, the FPC has compared the scenario that banks were tested against in this year’s annual stress test with a worst-case scenario that could be associated with a ‘no deal no transition’ Brexit. …
p7 Charts A, B and C
Maintaining Monetary Stability
Maintaining Financial Stability
… The severity of the UK economic stress in the 2018 stress test which the major UK banks have passed is significantly greater than the economic scenario for Brexit based on ‘worst case’ assumptions (see Chart D). …
1 EU Withdrawal and the Bank of England’s objectives
1.1 Monetary stability
… The MPC’s remit isto set monetary policy to achieve the Government’s target of keeping inflation at 2%. …
1.2 Financial stability
… The Prudential Regulatory Authority (PRA) … Financial Market Infrastructures (FMIs) …
2 Analytical foundations
2.1 Framework
2.2 Assumptions needed to characterise Brexit
2.2.1 Trade barriers
Chart 2.2.1: EU trade barriers over time show the rising importance of non-tariff barriers
2.2.2 Tariffs
… A simple unweighted average of EU MFN tariff rates was 5.7% in 2016. The trade-weighted-average MFN tariff rate, with weights given by the share of each good imported in overall imports, was lower ? at 3.2 per cent, as shown in Chart 2.2.1.
2.2.3 Non-tariff barriers
… NTBs include ‘at the border’ measures such as customs checks, including for compliance with rules of origin requirements. They also include ‘behind the border’ measures such as regulatory barriers and product standards. These include sanitary and phytosanitary rules (e.g. restrictions for substances, hygienic requirements, measures for preventing dissemination of disease and related to food safety), technical barriers to trade (e.g. labelling and certification), non-technical measures such as measures to protect intellectual property and rules on public procurement…
… ad-valorem tariff equivalent (AVE) of NTBs …
…find that the average AVE of NTBs can be as high as 48%, and find that existing NTBs almost double the level of trade restrictiveness imposed by tariffs…
2.2.4 Third country and new trade deals by virtue of EU membership
2.2.5 Preparedness for EU withdrawal
… The extent of disruption at the border and to transport and financial services will depend on the extent of preparations made in advance by firms and in critical infrastructure. HMRC estimates that between 145,000 and 250,000 trading firms who have not previously completed a customs declaration will need to do so in the event of no deal. …
… A Confederation of British Industry (CBI) survey found that 41% of companies had carried out some of their contingency plans…
… A CBI survey suggests that nearly 44% of businesses are planning to stockpile goods in the future, while 15% have already done so. Consistent with this, the Bank’s Agents report only limited stockbuilding so far, with many firms planning to do so through Q4 and in the New Year. A study by the Centre of Economics and Business Research (CEBR) estimated that three months’ worth of stockpiled raw material and semi-manufactures usually imported from the EU, plus one month’s worth of finished manufactures, would require ￡34bn in additional imports before 29 March.
Box 2A: UK companies’ preparedness for EU withdrawal: evidence from the Bank’s Agents
2.2.6 Impact of Brexit on financial conditions
2.2.7 Impact of Brexit on uncertainty and view of future prospects
2.2.8 Response of macroeconomic and macroprudential policy
…the UK Countercyclical Capital Buffer (CCyB)…
2.2.9 Migration policy
2.3 Established empirical relationships
2.3.1 Estimating the impact on trade of alternative trade arrangements using a gravity model
… The models bear out two clear empirical regularities that trade between two countries depends positively on their size and negatively on the distance between them. To take an example from a recent OBR Discussion Paper, the UK’s trade with India is almost six times as large as the UK’s trade with Pakistan; while the two countries are both similar distances from the UK, Pakistan has a smaller economy than India. India’s economy is of roughly similar size to that of Italy, but because Italy is much closer, the UK’s trade with Italy is twice as large as that with India (trade between Italy and the UK will also have benefited from mutual membership of the EU).
…leaving the EU will decrease trade between the UK and EU members but, over time, it will also make the UK relatively less isolated from other countries, partially offsetting the reduction in trade from leaving the EU.
2.3.2 The economic relationship between trade openness and productivity
… That increases the incentive for firms to innovate (Grossman and Helpman, 1991, Aghion and Howitt, 1998), especially for more productive firms (Aghion et al., 2018). …
… Mayer, Melitz and Ottaviano (2016) show how increases in demand from key foreign markets led French exporters to focus their export sales towards their best performing products and expand the range of products sold. …
2.3.3 The economic relationship between foreign direct investment and productivity
… For instance, foreign ownership of a firm is associated with higher labour productivity. Recent work by the ONS (2017) shows that the productivity of the average UK firm involved in FDI activities was around three times higher than that of firms not involved in FDI in 2015. …
… Empirical evidence of such effects in the UK can be found in Haskel et al. (2007), who find that there are foreign investment ‘spillovers’ to domestically-owned firms in the same industry. …
2.3.4 Estimates of the impact of a reduction in trade openness and lower FDI on productivity
… For example, Barattieri, Cacciatore, and Ghironi (2018) show how tariffs reallocate production toward less efficient domestic producers, lowering aggregate productivity, as well as lowering investment in physical capital and the production of new varieties of products. …
… Feyrer (2009b)… Felbermayr and Groschl (2013) …the 0.16 to 0.74% range…
… Pain and Young (2004) estimate significantly larger long-run effects, with a 1% increase in the stock of FDI increasing productivity by 0.32% in the UK manufacturing and distribution sector, and 0.13% in the financial services sector. …
Taking the trade and FDI effects together…based on an estimate that a 1% fall in openness eventually reduces productivity by 0.3%.
2.3.5 The speed of impact from a reduction in openness
…the reduction in trade flows associated with leaving a trading arrangement, and their eventual impact on productivity, are similar in magnitude to the effects of lowering trade barriers. …
More uncertain is the timing of such effects. … Baier et al (2014) …
… As discussed in Box 2C, Commonwealth countries lost their preferential access to UK markets in 1973, when the United Kingdom joined the European Economic Community (EEC). …once new trade barriers came in, the level of exports fell very quickly, and this rapidly fed through to economic growth and investment.
Box 2B: The impact of EU withdrawal on sectors and supply capacity
Box 2C: New Zealand trade after 1973: a case study of trade disruption
2.3.6 Using empirical relationships to model the further economic impact of these changes in trading relationships
Openness and the exchange rate
Uncertainty and spending decisions
Economic and Financial conditions
… Cloyne et al. (2015). …the impact of changes in credit conditions and financial yields on the behaviour of households, firms and the financial sector. …
House prices
Relative economic performance and migration
The ONS’ latest principal population projection is based on an assumed path for net inward migration to the UK that declines from around +250k per year in 2016 to +165k per year from 2023. …
Box 2D: Tariff and exchange rate effects by sector of the CPI basket
3 Scenarios
… Sterling fell sharply immediately following the referendum, and remains 18% below its 2015 peak before the referendum was called. This has pushed inflation above target, and squeezed household incomes as a result. At the same time, Brexit-related uncertainty has depressed investment and held back productivity growth. …
3.1 Scenarios in which the UK and EU implement the Economic Partnership
..two variants of the Economic Partnership, labelled as ‘Close Economic Partnership’ and ‘Less Close Economic Partnership’, which form the top and bottom of a range of possible characteristics of the Economic Partnership. …
3.1.1 Assumptions underpinning the Economic Partnership scenarios
The two scenarios… share assumptions on migration and the way in which policy is set.
Table 3.1.1: Key assumptions
3.1.2 Modelling the effects of these assumptions on the economy
Table 3.1.2: Key economic relationships
3.1.3 Overall impact
… The level of GDP is between 1?% and 3?% lower than the May 2016 trend by end-2023. Relative to the November 2018 Inflation Report projection, by end-2023 it is 1?% higher in the Close scenario, and ?% lower in the Less Close scenario. …
Chart 3.1.1: Range of GDP outcomes in Economic Partnership scenarios
Chart 3.1.2: Range of unemployment outcomes in Economic Partnership scenarios
Chart 3.1.3: Range of inflation outcomes in Economic Partnership scenarios
3.2 Worst case macroeconomic scenarios for assessing UK financial system resilience
… A more testing scenario would be a Brexit scenario with a cliff-edge in March 2019 ? a “no deal with no transition” outcome. …
…the FPC has considered the particular risks that could arise if the UK’s relationship with the EU were to move abruptly to default World Trade Organisation (WTO) rules without an implementation period. …
3.2.1 Macroeconomic scenarios for a Brexit with no deal and no transition
Table 3.2.1: Summary of assumptions made in “No deal, no transition” scenario
3.2.2 Assumptions in no transition no deal scenarios
3.2.3 Additional assumptions for the disorderly Brexit scenario
Table 3.2.2: Key economic relationships which generate the economic outcomes
Table 3.2.3: Comparison of Brexit scenarios with no agreement and no implementation period with other stress episodes
Chart 3.2.1: Range of GDP outcomes in no deal, no transition scenarios
Chart 3.2.1: Range of unemployment outcomes in no transition no deal scenarios
Chart 3.2.2: Range of inflation outcomes in no transition no deal scenarios
4 Maintaining monetary stability
4.1 Demand
4.2 Supply
4.3 Exchange rate and tariffs
4.4 Implications for monetary policy
5 Managing the Ongoing Risks to Financial Stability
5.1 The UK is Home to the World’s Leading International Financial Centre
5.2 Managing risks of a No deal and No Implementation Period scenario
… The 2018 stress test (ACS) shows that the UK banking system is resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the global financial crisis, large falls in asset prices and a separate stress of misconduct costs. …
In the ACS, UK GDP falls by 4 3/4 %, the UK unemployment rate rises to 9 1/2 %, UK residential property prices fall by 33% and UK commercial real estate prices fall by 40%. The scenario also includes a sudden loss of overseas investor appetite for UK assets, a 27% fall in the sterling exchange rate index and Bank Rate rising to 4% (Table 3.2.3). …
Table 3.2.3: Outcomes in disorderly ‘no transition no deal’ scenario and 2018 ACS stress test
Chart 5.2.1: Comparison of the impact of the disorderly Brexit scenario and 2018 ACS on major UK banks’ capital ratios
5.3 Financial Stability Implications of an Implementation Period
… As regulator for the largest financial sector in the EU, the Bank of England has advised and supported the UK Government in the EU legislative processes and influenced the EU authorities in the development of binding technical standards. The Bank has played an active role in the European Systemic Risk Board (ESRB).
During the Implementation Period, the UK will not be a member of, or have a regular voice in, the main supervisory cooperation structures – the European Supervisory Authorities…
5.4 Declaration on the Economic Partnership
5.4.1 Equivalence as the basis of the future partnership on financial services
… The Northern Ireland backstop incorporates no provision for the regulation of financial services. The position after the Implementation Period will therefore depend on whether any specific arrangements on financial services have been agreed. Absent such an agreement, WTO rules for financial services would apply. …
… The White Paper ‘The future relationship between the United Kingdom and the European Union’ (“the White Paper”) …
…maintaining cross-border activity through equivalence provisions would require the UK and EU regulatory regimes to produce sufficiently similar outcomes on an ongoing basis. There could, over time, be pressure for the UK to maintain a closer alignment to the EU than it would otherwise choose in order to maintain equivalence. At one extreme this could result in the UK becoming a de facto rule-taker. …
Appendix A Impact on the UK economy of a transition to WTO
A.1 Assumptions underpinning the transition to WTO scenarios
A.2 Modelling the effects of these assumptions on the economy
A.3 Overall impact
Appendix B External studies of the impact of Brexit
B.1 The impact of Brexit on the UK economy to date
B.2 Estimates of the long-run impact of Brexit
Appendix C Scenario assumptions
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Bank of England governor warns no-deal Brexit could cause recession – as it happened (08/02/2019) | @guardian
https://www.theguardian.com/business/live/2019/feb/07/bank-of-england-brexit-interest-rates-mark-carney-business-live
https://www.thisismoney.co.uk/money/news/article-1607881/When-UK-rates-rise.html
https://www.bloomberg.com/news/articles/2019-02-07/boe-cuts-forecasts-says-brexit-damage-to-economy-has-risen
https://www.cnbc.com/2019/02/07/bank-of-england-interest-rate-decision-amid-brexit-uncertainty.html
https://www.cnbc.com/2019/01/24/bank-of-england-brexit-preparing-since-the-vote-to-leave-carney.html
https://www.marketwatch.com/story/what-the-bank-of-england-would-be-doing-if-it-werent-for-brexit-2019-02-06
